The author is a Forbes contributor. The opinions expressed are those of the writer.

Loading ...

Loading ...

This story appears in the {{article.article.magazine.pretty_date}} issue of {{article.article.magazine.pubName}}. Subscribe

The votes are in: Obama stays, and all eyes are on January. Taxes will most likely go up and interest income will remain low.

Dividend stocks, prized for their attractive income and low tax rate of 15%, may loose their attractiveness. We could see their tax rate rise to above 40% in 2013, which would no doubt dampen an income-oriented investor’s drive to buy dividend stocks. In our continued search for investment returns, are there other sources of more tax efficient income out there?

Companies are still flush with cash, but they may not continue to raise their dividends, given the impending tax reform. You can also be assured that investment activists will pressure companies to get that cash working somehow.

As large hoards of cash threaten to grow even larger while the new tax scenario plays out, companies generally have three alternatives for cash: acquisitions, expansions, or stock buybacks. In trying to figure out where CFO’s will spend corporate cash in 2013, let’s take a look at the options to see why I predict that buybacks will trump the other alternatives.

I think strategic acquisitions are the least likely of the three options available, because M&A work demands lots of resources, legwork and due diligence. Since all this analysis takes time, the cash buildup would continue while investment bankers present prospective deals to the company’s M&A team. The excessive cash balance burden could cause more urgency, which may lower the quality of objectivity required to vet deals appropriately.

On top of that most companies will be scared off this path by ’s recent fiasco involving its acquisition of Autonomy Corp. That recent news does not set the stage well for future acquisitions by companies unless they have done their homework extremely well. Bottom line: it will take even longer to fully conduct due diligence so your company won’t buy the next Autonomy situation.

If acquisitions are out, this leaves the choice between dividend increases or stock buybacks.

From a stockholder’s perspective, I find the buyback scenario more probable because the new tax rate applied to capital gains (formerly 15%) will most likely be raised to 20%. That’s painful, but not as bad as the rate increase dividends could see.

While the dividend raise is an instant increase in taxable income, investors that choose to hold their stock after a buyback is announced (or even beyond the actual buyback event) may see their investment increase without realizing a taxable gain. That gives investors a little discretion about realizing a gain if the stock should increase as a result of the buyback’s boosting the outlook for the company’s stock performance.

From the company’s perspective, there are other reasons why buybacks may displace dividend increases in 2013. In recent quarters, earnings results have been mixed: only 30 percent of companies beat on revenues, but 70 percent beat on earnings. Most likely cost cuttings, not revenue increases, drove the better earnings results. That means future earnings beats will probably not come from cost reductions or revenues increases, since most companies have already exhausted those drivers for the time being.

The outlook for earnings growth by traditional means may be on hold for now, forcing a CFO to look for other tools available to do the job. A CFO, when pressed to consider how to deploy cash, may conclude that the buyback could be the better option to boost stock prices. Evidence is debatable, but some data suggests stock buybacks have a better chance to boost a stock than dividend increases.

There has been a lot of buyback activity already, and I suspect it will heat up into next year. In the table below, I have screened stocks with market caps above $1 billion that have recently announced buybacks during 2012. I also assumed the companies could use less than 25% of their balance sheet cash to fund the buybacks if they wanted. I then optimistically modeled the EPS impact by reducing the number of shares outstanding, while keeping earnings the same.

You can see that, even if earnings were flat, a buyback could impact the EPS calculation, thereby lifting the company’s performance based on earnings alone. This could lead to stock appreciation in some cases.

Buy in to Buybacks

Stock

EPS Impact

Health Net (HNT)

28%

Advanced Micro Devices (AMD)

25%

Tellabs (TLAB)

22%

Platinum Underwriters (PTP)

21%

Morgan Stanley (MS)

21%

LincolnNational (LNC)

17%

Dana Holding (DAN)

14%

E*Trade Financial (ETFC)

12%

Navistar (NAV)

12%

(CSCO)

12%

So move over dividend boosters—it’s time to make room for buybacks in your portfolio.